Foreword
I was a newbie to finance when I took this course, so this is a high-level take from me trying to understand the industry for the first-time and just “speak the language”. The following is a more qualitative intro to LBOs, and my notes are really rough.
Some Interview Qs
- What are the drivers of value in an LBO?
- Purchase Price / Entry Multiple Exit Multiple Revenue Growth EBITDA Margin Expansion Debt Paydown
- How can a Sponsor monetize its investment in a portfolio company?
- Sell the company fully or partially
- IPO
- Dividend Recap
- Transactions can be structured as either Stock Purchases or Asset Purchases. As a Sponsor, do you have a preference? Why or why not?
- Asset Purchase. Remember, Goodwill is created during Purchase Price Accounting. It is NOT amortizable for tax purposes in a Stock Purchase, but IS in an Asset Purchase, creating an additional tax shield. Furthermore, the write up of assets in a transaction (e.g. PP&E) also gets a step up in tax basis that is depreciable for tax purposes, whereas there is no step up in tax basis in a Stock Purchase
- What are typical covenants that you would expect to see on Bank Debt?
- Debt Ratios: Total Debt / EBITDA Net Debt / EBITDA
- Interest Coverage: EBITDA / Interest Expense (EBITDA - CapEx ) / Interest Expense
Yellow highlight drives FCF. Other items dependent on LBO (e.g. roll-ups).
Notes for Intro to LBOs
Three potential LBO value drivers: multiple expansion, debt paydown, EBITDA growth.
LBOs Defined: A leveraged buyout (LBO) involves buying a company primarily with borrowed money. For instance, if a company worth $100 million is bought using $80 million in debt and $20 million in equity, this is an LBO. Often, the assets of the company being bought are used as collateral for the loans.
Equity Contribution: In an LBO, the buying firm might only contribute, say, 20% of the purchase price in equity, borrowing the remaining 80%. This is akin to making a down payment on a house and financing the rest.
Cash Flows and LBOs: A company being acquired in an LBO should have stable cash flows
Reasons for LBOs: A managerial team might opt for an LBO to buy out the company they work for. Alternatively, a conglomerate might use an LBO to sell off a division that doesn't fit its core mission. Sometimes, LBOs are used to transition a public company back into private hands. Other times, PE purchaser. Multiple reasons.
Debt Repayment: Using cash flow from operations to paydown debt (can sweep it or have bullet repayment).
Exit Strategies: Aim to sell it, perhaps to another company or PE fund, or they might even decide to take it public through an IPO.
Value Creation: After an LBO, the new owners might streamline operations to reduce costs, pursue aggressive sales strategies to boost revenues, or restructure debts for better terms, all in the pursuit of increasing the company's value.
Operating Improvements: The new owners might renegotiate supplier contracts or optimize product offerings to enhance profitability post-acquisition. Might rationalize cost structure.
Multiple Expansion: If a private equity (PE) firm acquires a company at 5x its EBITDA but can sell it later at 7x EBITDA, this difference can yield substantial returns.
- These return streams can be disaggregated to understand how much value came from multiple expansion, debt paydown and EBITDA growth
LBO Modeling: Investment professionals use LBO models similarly to assess potential acquisitions.
Sources and Uses: This section is like a budget, detailing the acquisition's total cost (i.e. cost of purchasing the company, transaction expenses, debt finance fees, minimum cash on balance sheet) and how all of that is funded (combination of debt, new equity, rolled over equity etc).
Debt Schedules: This is a detailed plan, illustrating how the company intends to repay its debt over time, including interest and principal payments. Different debt tranches are paid in levels of seniority based on legal docs. Can do a cash sweep where you use all or % of FCF generated to paydown debt, or you can have mandatory debt repayments etc. This is part of the debt negotiation process.
Sensitivity Analysis: This examines scenarios, like "What if revenue growth is only 1%?" or "What if the exit multiple is just 6x?" Same output, sensi tables.
IRR and MOIC: IRR being effective annual compounded interest rate of return, MOIC being multiple of invested capital.
Equity Bridge: Getting from Enterprise Value to Equity Value, you’ll adjust for net debt (and negotiate on a swathe of other items to include)
Ticker: May have to pay a % of equity value based on transaction timing to compensate seller for delays etc (to be negotiated)
Refinancing Options: After an LBO, the company might find a bank offering a lower interest rate on its debt, much like a homeowner refinancing a mortgage.
Dividend Recaps: Imagine a company deciding to take on an additional $10 million in debt post-LBO, using this money to pay a special dividend to its PE owners.
Tax Considerations: Just as individual tax planning can affect one's returns, the way an LBO is structured can influence overall profitability.
Due Diligence: Before a house purchase, a buyer would inspect the property. Similarly, before an LBO, the buying entity would meticulously evaluate the target company's financials, operations, and any legal issues. This DD is extensive, advisors hired, happens on multiple fronts.
Covenant Structures: These are like terms and conditions on a loan, which the borrowing company must adhere to.
Management Incentives: After an LBO, the management might be given stock options, ensuring their goals align with the new owners.
Synergies: If a tech company buys another tech firm through an LBO, they might save money by merging their IT departments, or boost sales by cross-selling products. So you can have revenue and cost synergies and you can track realizations etc. Can be group-level, segment level, could do a merger or a bolt-on.
Regulatory Environment: Potential legal or regulatory issues, such as antitrust concerns, can influence LBO decisions.
Debt Terms: These dictate the rules of the borrowed money, like how long the company has to repay it and the interest rate.
Equity Contribution: This is like the down payment in the LBO, providing a safety net (cushion) for lenders. Equity can be new or rolled over from existing investors or management.
Exit Timing: Selling the company when the market is booming can fetch a higher price, much like selling a house in a seller's market. Quicker cash flows received, higher IRR, but may trade-off on potential MOIC if you held for longer.
Holding Period: This refers to how long the PE firm retains its investment post-LBO. It can affect metrics like IRR and MOIC (as mentioned above).
Monitoring Post-LBO: This involves regularly checking on the company's performance, much like a landlord might periodically inspect a rental property.